UK property dance begins again

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The music is playing again in UK commercial property and the dancers are getting to their feet. They may well regret their exuberance.

Market participants have become more optimistic, largely because of a prevailing sense that things can’t get much worse. Capital values have, after all, fallen 45 percent since the high while rents have slumped by a third or more.

Buyers are beginning to sniff around the property market again. Distressed real estate investors are itching to put money to work, while foreign buyers such as sovereign wealth funds are keen to snap up sterling assets while the pound is weak.

Meanwhile the banks have started lending again. The number of banks prepared to lend for transactions worth more than 20 million pounds has nearly doubled since March, while at least six will fork out more than 100 million pounds, according to Savills. Low interest rates means the all-in cost of financing is historically low for purchasers (about 6 percent or less for prime office properties).

However, while financing costs are low, the number of transactions completed is still tiny, and it would be foolhardy to presume that the credit markets are up and running again. Sales above 10 million pounds have fallen more than 41 percent since last year. But most of the interest — from both buyers and lenders — is in prime city properties, not industrial warehouses or retail parks.

The relatively benign macro-economic circumstances could also turn nastier. Funding costs are vulnerable to both a rise in interest rates, or an increase in demand. Rising unemployment would depress rents further.

Then there are structural issues left over from the previous bubble that remain unresolved: the troubled real estate loans on banks’ balance sheets, and the amount of debt that must be refinanced in coming years.

Banks are still holding back on repossessing properties secured against troubled loans. Most UK commercial real estate loans are in negative equity (as much as 71 percent, according to Barclays Capital). This is a combination of prudence and desperation. Repossessing now would involve a loss for the bank, while further property falls would hurt everyone. Better to wait and pray for a recovery.

Yet that still leaves the issue of maturing debt that can’t be refinanced. Barclays Capital estimates as much as 160 billion pounds of debt in negative equity will come due in coming years. Much of it will be of unloved secondary properties. As loans go bad banks will face higher capital charges and more pressure to seize properties. A rise in delinquent loans will also cause banks to conserve capital and rein in lending to the property sector.

The next few months offer investors a good chance to lock in cheap funds and high yields — provided they can get their hands on the right properties and the credit. But there is no certainty that the rebound will continue. The recovery could be weak and long. Worse, a perfect storm of rising defaults, forced sales, tight credit and falling rents is still a possibility.